This year's Budget bodes well for the mutual fund industry and fund investors. Most people in the industry were relieved that the Government didn't implement the Kelkar committee's recommendation of taxing short-term capital gains of mutual funds.

As for investors, dividends from all mutual fund schemes are now tax-free. Debt mutual funds, however, now have to pay a dividend distribution tax of 12.5 per cent.

Equity funds and the UTI-I have been exempt from paying distribution tax.

However, the exemption on capital gains tax given to listed shares acquired after March 1, 2003, will not be applicable to mutual funds.

Long-term capital gains tax on equity funds stays at 20 per cent with indexation benefits, or 10 per cent without indexation benefits, whichever is lower.

Given the current changes in tax structure, here are some tax-efficient options you could consider before investing in mutual funds. We also look at how the fund industry will be impacted by the Budget.

For the equity fund investor

If you are an equity fund investor it makes sense to switch to a dividend option as there is no dividend distribution tax levied and the dividends are tax-free in the hands of investors. So your entire returns become tax-free.

For the debt fund investor

If you swear by debt funds the best option would be to go in for the growth option with Systematic Withdrawal Plan.

Though the dividend is tax-free in the hands of investors, debt funds still have to pay a dividend distribution tax of 12.5 per cent.

The effective tax rate under the SWP is around 1.41 per cent for investors with an annual income of up to Rs 8.5 lakh.

For investors with an annual income above Rs 8.5 lakh the effective tax rate is slightly higher at 1.55 per cent because of the 10 per cent surcharge. So, opting for a SWP definitely makes more sense.

For the mutual fund industry

The mutual fund industry was by large happy with the Budget. Fund managers say that despite the obvious benefits extended to equity funds, debt funds will still find favour with investors.

They claim since administered interest rates on PPF and small-savings have been reduced by one per cent and the savings bank rate reduced to 3.50 per cent, retail investors will be compelled to turn to mutual funds to boost returns.

Even for corporates who traditionally are large investors in debt funds, the switch to dividend distribution tax will be more beneficial.

Corporates use liquid and short-term debt funds to park their surplus and usually stay invested only for short periods.

So they were required to pay short-term capital gains tax at the marginal rate of 36.75 per cent.

Now with the dividend distribution tax at 12.50 per cent there is definitely a saving of 24.25 per cent on taxes. Also with the government reiterating its stance on a softening bias towards interest rates with numerous rate cuts, it gives debt funds a chance to overreach themselves in the short-term.

However increasing volatility and the possibility of gains being limited remain strong concerns.

Fund managers don't see a huge switch from debt to equity funds in the near term. Pure equity schemes constitute only around 12.5 per cent of the total assets under management of the mutual fund industry.

While balanced schemes make up for another 11 per cent, the balance is made up by debt schemes. Even for a small change in the equation there has to be significant inflows into equities. This may not happen for two reasons.

Traditionally most big ticket investments in debt funds have been by corporates and they are not likely to switch to equity funds as they are far too risky.

Second, even in the case of retail investors fund inflows into equity funds have been the highest only during a bullish market.

Says Milind Barve, managing director, HDFC Mutual Fund: "Investors have only invested in equity funds when they see some performance- which usually is during a bull market."

If one were to look at the numbers it definitely looks like it.

Given the free fall in interest rates in the past three years, assets under debt schemes rose a dramatic 80 per cent since January 2000.

On the other hand assets under management in equity schemes shrunk by almost 40 per cent during the same period as equity markets sank without a trace after reaching dizzy heights in early 2000.

The minor recovery last year saw assets under management of equity schemes grow by around 12 per cent.

So a mere change in the tax structure may not result in a switch from debt to equity.

However, given that the return prospects are brighter for equities this year, equity funds could definitely see increased inflows though debt funds may not see dramatic outflows.